Don’t Get Penalized for Substantial Valuation Understatements

Estate Planner Mar-Apr 1997
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Many of the techniques currently used for estate planning rely on minimizing the value of transferred assets. Discounts are most commonly sought for lack of control, lack of marketability and minority interests. The Internal Revenue Service (IRS), however, imposes penalties for substantial estate and gift tax valuation understatements.

Outright gifts of parcels of real estate, marketable securities or stock in closely held businesses are often less than optimal. Instead, before gifts are made, it can be better to segment or combine assets and place them in family limited partnerships (FLPs) or limited liability companies (LLCs) and convert them to nonvoting or noncontrolling interests, or funnel them through grantor retained annuity trusts. The same type of planning is also used in anticipation of valuing an asset for estate tax purposes.

Reports circulate of cases where a combined 55%, 65% or even 85% discount from fair market value was allowed, or where everyone takes at least a 25% discount. Accordingly, you may be tempted to view discounting as less than an exact science. It is at this point, however, that you need to be mindful of the penalties for substantial estate and gift tax valuation understatements.

What Is an Understatement?

The valuation understatement can apply when the value of any property reported on a gift or estate tax return is 50% or less of what the court determines to be the current value of property. The IRS imposes a penalty of 20% of the amount of tax underpayment and increases the penalty to 40% for reported understatements of 25% or less of the current value.

For example, you place an interest in a closely held business into an FLP with an interest in real estate, at a combined value of $2 million. You make a gift of a 2.5% FLP interest. For gift tax purposes, you take a 60% minority-interest and lack-of-marketability discount, and value the gift at $20,000 ($50,000 x 40%). You and your spouse split the gift, each claiming a $10,000 annual exclusion gift.

The IRS contests the valuation, and the case goes to court. The court finds that the fair market value of interests that went into the FLP was actually $2.5 million and that the proper discount for the minority interest was 25%. This results in the gifted 2.5% interest being valued at $46,875, making the split gifts each about $23,438. The valuation understatement is by more than 50%, and the IRS could add a penalty of 20% of the tax underpayment.

Reasonable Cause

The penalty for valuation understatement is not imposed if there was reasonable cause and you acted in good faith. In several recent cases the courts have held that the IRS abused its discretion by refusing to grant a waiver of the valuation penalty for reasonable cause.

In one case, the taxpayer had relied on the advice of an accountant with valuation experience and on the opinion in a prior tax court case. In another case, the taxpayer had relied on an appraiser’s opinion, and, even though the court was critical of the appraisal, it held that the taxpayer had substantive support for its position and reasonable cause existed. In a third case, the taxpayer relied on the advice of the company’s long-time outside counsel and accountant, even though the taxpayer had agreed to higher valuations for the same property on prior gift tax audits. The court noted that the IRS audits did not bind either party as to valuation in future years.

Support Your Valuations

Gifts to family members or for valuing assets on an estate tax return are not required to be supported by a qualified appraiser. Nevertheless, a good appraisal can provide reasonable cause for the waiver of an undervaluation penalty. At minimum, the valuation process should involve the advice of an experienced and competent accountant or lawyer.